The Forex Food-chain
Just as it can be easy to miss the deeper market trends when monitoring currency pairs at shorter time frames, it can also be easy to lose sight of the wider forex-trading ecosystem when you’re overly concerned with the minor price fluctuations of your open positions.
The forex market is a world unto itself, with all manner of players, from individual traders like you, all the way up to the interbank network and central banks. As an individual retail trader you are the smallest fish, you have the ability to buy and sell the same currency pairs as other participants, but you are have to go through a longer transaction chain than others in order to get hold of liquidity, as such you don’t receive the same prices as participants further up the hierarchy. You are also unable to affect the market with your trades because you are far too small to make any waves. Your role is to react to what is going on in the wider market and to position yourself accordingly. While this may seem like a disadvantage; it also comes with its advantages as we will see further on. Learning about all the entities that are large enough to move the waters, as well as knowing how and why they do, will be important to you as a trader. Understanding the wider structure of the market allows you to make educated choices and reduce the degree of randomness in your trading.
Governments /Central Banks.
Central banks such as The Bank of England, The Federal Reserve and the European Central Bank are responsible for managing money supply and interest rates, as well as supervising their respective commercial banking systems. They are the blue whales of the forex-market. As part of their remit to manage growth and currency stability, central banks exert a tremendous influence on the forex market.
As part of their open market operations (OMOs) central banks control the money supply and stabilise interest rates through repurchase agreements (repos) with commercial banks (primary dealers). Repurchase agreements effectively work to increase the money supply in an economy when central banks lend money out (by purchasing treasury bills from the banking sector), or in the case of reverse repos to take money out of circulation when borrowing money (by selling treasury bills to the banking sector).
When spending outpaces production (more demand than supply) prices rise, this is called inflation. When faced with inflation central banks also have the power to directly raise interest rates, this increases the price of credit, making the servicing of existing loans more costly and the prospect of borrowing less attractive.
When production outpaces spending (more supply than demand) prices fall, this is called deflation. When faced with deflation central banks can lower interest rates, reducing the price of credit, which makes it cheaper to service existing loans and more attractive to borrow money.
What we have come to understand as a free market actually refers to a very delicately managed ecosystem, which is kept in balance through periodic intervention by central banks. There are several reasons central banks are located at the top of the Forex food chain. They are the only entities in the financial system with the ability to bring money in and out of existence, they set interest rates, influence the market’s expectations and normally hold very large currency reserves (the most popular by far being the US dollar and the euro). The influence that central banks can exert on the FX market when adjusting their own currency reserves can be substantial owing to the sheer volumes they are able to generate.
Comprised of banks and large financial institutions, institutional dealers provide liquidity to the FX market. Dealers trade with each other on the interbank market, an electronic communication network backed by lines of credit between participating institutions. Broadly speaking the interbank market is a network of institutional FX dealers that trade currencies between themselves in order to keep the banking system liquid. According to data compiled in 2013 by the Bank of International Settlements, the interbank network accounts for around 40% of the forex market’s $5.3 trillion daily turnover.
Banks and large financial institutions trade with each other in order to ensure that they are liquid enough to satisfy the needs of their customers. Their customers range from other smaller banks without the credit relationships necessary to participate on the network, companies who require foreign exchange as part of their import and export cycle, forex brokers who act as intermediaries between the big banks and retail traders, and retail clients requiring access to cash and credit services. These institutions are able to borrow directly from central banks at wholesale prices, allowing them to access liquidity at better prices than all other market participants further down the chain. Their profits stem from the premiums they charge for the liquidity they provide to smaller institutions, companies, brokers and retail clients.
Primary dealers set the exchange rates on the currency pairs you trade. Forex being an entirely decentralised market there is no one price for any one currency pair, rather each institution will quote slightly differing prices depending on its own supply and demand dynamics. When we quote prices to our clients we aggregate the best bid and ask prices from our liquidity providers and execute your orders at the volume-weighted average price after charging either a commission (cTrader) or applying a small mark-up to the spread (MT4).
As part of their monetary policies, central banks set the rate at which commercial banks may borrow money (via repo we mentioned earlier) from the central bank. This lending rate will then dictate the rate at which banks lend between themselves. Owing to different supply and demand conditions the actual rate at which these transactions take place is constantly changing. These rates are known as libor rates. Libor rates are quoted from 1 week to 1 year. The longer the term, the less they are determined by the central bank rate. If I am a bank and want to lend you money for six months, the rate I charge is dependent on what I expect my funding costs to be over the coming 6 months. If I expect the central bank will lower its lending rate to me, then I will set the rate lower.
Twice removed from central bank liquidity we find the companies that also require access to the foreign exchange market. Businesses are among the largest clients of institutional dealers. This is because foreign exchange is essential to international commerce. Any international transaction involving selling products and services to clients or purchasing them from suppliers requires the buying and selling of foreign currencies. Globalisation has led to foreign exchange transactions being an indispensable part of the business cycle.
For example: An American consumer electronics giant orders components from Japan for its new line of products. It will have to settle the bill six months from the order date in Japanese yen. The company will have to purchase a large amount of yen with US dollars in order to do so. This can have a noticeable effect on the USD/JPY exchange rate when the transaction takes place. However the forex market being what it is, by the time the payment is due JPY may have risen against USD making the order more costly for the American company, thus throwing out its profit margin. The company may choose to exchange dollars for yen in advance in order to be certain of how much the transaction will cost, however this being a large order, it is unlikely that the company has sufficient cash reserves to purchase the required yen outright on the spot market and hold on to them until payment is due.
In order to hedge against the risk of an unfavourable exchange rate at a later date the firm may decide to enter into a forward or future contract with a willing party. This is done in order to hedge against market volatility and to guarantee that six months down the line the company will be able to purchase the required JPY to meet its obligations at the current price.
Another reason forex is so important to multinationals is that when conducting business in foreign markets they regularly have to repatriate funds. Depending on the size of the company this may be require extremely large foreign exchange transactions, which even when divided into separate orders will move the respective prices of the underlying currencies.
Traders are perhaps the most diverse group of market participants. Their influence depends on the capital they have at their disposal and how high up the hierarchy their liquidity is sourced from, meaning they can be located almost anywhere on the forex food chain. One thing, however, does unite all traders; the forex market is not something they use as a tool to help them conduct their everyday business, for them the FX market is their business. Traders are not interested in using the forex market to hedge against the risk of future purchases, or even to actually take possession of the currencies they trade. Traders are only concerned with profiting from price fluctuations, and what better market for them to trade on than the largest and most liquid in the world?
Hedge funds are one of the most impactful groups of currency speculators and can easily influence currency values due to the sheer size of the trades they regularly place. They are also among the most knowledgeable and experienced market participants. Hedge funds invest on behalf of individuals, pension funds, companies and even governments. They employ a number of different techniques including discretionary trading, algorithmic trading, a combination of both and fully automated high frequency trading. They also have very deep pockets and the power to make huge waves.
It may come as a surprise, then, that one of the most famous currency speculations of all time was made by an individual trader. In 1992 George Soros, an investor now known as “the man who broke the bank of England” used $1 billion (the entire value of his fund) with 1:10 leverage to short the pound sterling against the deutsche mark to the tune of $10 billion. The logic behind the trade being that sterling was overvalued due to the Bank of England refusing to devalue its currency after joining the Exchange Rate Mechanism (ERM) in 1990. Within 24 hours the sterling had dropped by around 5,000 pips. Soros liquidated his position a month later profiting from the now more valuable deutsche mark and walked away with $2 billion. Of course you as an individual retail trader are a far cry from the George Soroses of this world. Even at maximum leverage your positions are bound to be worth but a fraction of the trades that wealthy investors like Soros are able to command.
If you are dealing with a market maker then your buy orders are offset by the identical sell orders of other clients. By matching orders in this way brokers can keep them on their own order books and remain risk neutral. However, in practice a market maker’s books rarely ever match up this neatly, making it necessary for them to hedge risk by taking their own counter-positions on the “real” market. This is where the conflict arises, by trading against you when your orders can’t be reconciled with other orders on the book, your profit becomes your broker’s loss and your loss becomes their profit.
Brokers like FxPro, who do not act as market makers and do not take on proprietary risk; forward client orders directly through to the dealing desks of the institutional dealers they source their liquidity from. When dealing with true ECN brokers like us you receive the best respective bid and ask prices from a number of institutional liquidity providers and your orders are executed at the volume-weighted average price.
In the following section we will look a little closer at the retail forex market and at some of the advantages of being a small fish in a huge ocean.